Is Tax Diversification Good or Bad for Investments?

What is Tax Diversification?

Tax diversification refers to a strategy or approach used by individuals to manage their investments and retirement savings in a way that allows for flexibility in managing their tax liabilities. It involves diversifying the types of investment accounts and vehicles used to save and invest, with the aim of having a mix of taxable, tax-deferred, and tax-free accounts.

The main idea behind tax diversification is to spread out your investments across different tax treatments so that you have options when it comes to withdrawing funds in the future. By having a variety of taxable and tax-advantaged accounts, you can potentially minimize your overall tax burden and maximize your after-tax returns.

Three Main Categories of Accounts (the Tax Triangle) That Are Typically Considered for Tax Diversification:

1. Taxable Accounts: These are regular brokerage accounts where you invest with after-tax dollars. While you may be subject to capital gains tax when you sell investments for a profit, you have more flexibility in terms of accessing the funds without penalties or restrictions. Examples include an individual account, a brokerage account, or a revocable trust account.
2. Tax-Deferred Accounts: Examples of tax-deferred accounts include traditional Individual Retirement Accounts (IRAs) and employer-sponsored retirement plans like 401(k)s or 403(b)s. Contributions to these accounts are made with pre-tax dollars, which can reduce your taxable income in the year of contribution. However, withdrawals from these accounts in retirement are generally subject to income tax. Tax-deferred accounts offer the advantage of potential tax savings in the present, but taxes will be due on the withdrawals.
3. Tax-Free Accounts: Roth IRAs and Roth 401(k)s are examples of tax-free accounts. Contributions to these accounts are made with after-tax dollars, but qualified withdrawals, including earnings, are tax-free in retirement. These accounts can provide tax-free growth potential and flexibility in managing your future tax liabilities.

By having a mix of these types of accounts, you can choose how and when to withdraw funds in retirement strategically. So, should you intentionally aim to build investments in each of these baskets? Seems like a no-brainer, but here’s what you should avoid.

Avoid Becoming a “Sitting Duck” for Future Higher Tax Rates

Putting all your money in tax-deferred accounts can be risky because it leaves you vulnerable to potentially higher tax rates in the future. This is because you will eventually have to withdraw money from these accounts as required minimum distributions (RMDs). To diversify your tax strategy, consider investing in other types of accounts like taxable brokerage accounts or tax-free Roth accounts.

However, it’s also not advisable to solely rely on tax-deferred accounts because you may end up in a higher tax bracket during retirement. This can happen due to the large RMDs resulting from years of saving and investing, as well as reduced deductions compared to when you were earning money (such as not having a mortgage or children deductions). To address this, directing funds into a Roth IRA could be a smart move.

Ideally, you want to take advantage of deductions when tax rates are high and receive income when rates are lower. However, the tax system often penalizes savers, as the more you save, the more likely you’ll be impacted by higher rates in the future.

Tax Diversification Needs Strategic Planning

The primary objective of tax diversification should not be the ultimate goal of your investment plan. Many individuals mistakenly believe that it is ideal to have a mix of Roth, Traditional IRA, and taxable savings. However, the overarching goal should be to minimize tax payments as much as possible. For instance, if you are a young person embarking on your career, your focus should be on paying taxes when your tax rate is at its lowest, which often means choosing the Roth option exclusively. Nevertheless, there are also advantages for older individuals who own a Roth account. During retirement, no one wants to pay excessive taxes as there is no fresh income being generated. Roths offer the benefit of not requiring RMDs, and investors are not compelled to take distributions. This grants Roth investors peace of mind as their money continues to grow tax-free.

If given the chance to invest in a retirement account, such as a Traditional IRA or Roth IRA, it is generally not advisable to prioritize putting money into a taxable account over a retirement account. This is because you have the option to choose a Traditional IRA for its deduction benefits or a Roth IRA if you do not require the deduction.

Retirement Planning and Tax Experts at Mission Wealth

Your finances and your retirement are too important to leave up to chance. Make sure you talk through any big decision with a knowledgeable financial advisor or tax professional so that you can weigh the pros and cons of different options against your specific set of goals and objectives. Mission Wealth can guide you through the tax diversification decision-making process.